Compliance will play a major role in the banking-as-a-service sector in 2023

Banks involved in banking as a service will need to prioritize regulatory compliance in 2023 as scrutiny intensifies and opportunities in the segment grow.

Throughout 2022, several banking regulators have emphasized that they are increasing attention to the banks’ third-party risk. In one example, the Office of the Comptroller of the Currency went into a formal written agreement in August with Blue Ridge Bank NA, the banking subsidiary of Blue Ridge Bankshares Inc., to strengthen the OCC’s oversight of the bank’s fintech partnerships.

Regulators’ announcements help raise banks’ awareness of risk management and do not necessarily kill banks’ interest in BaaS, industry experts said. Despite higher regulatory risk, the BaaS business model has delivered favorable financial results for existing banking players compared to the industry average.

“Bank/fintech partnership going nowhere,” Mark Chorazak, a partner at Shearman & Sterling in the financial institutions advisory and financial regulatory practice, said in an interview. “The nature of these partnerships will evolve, not only given the increasing regulatory scrutiny, but also given the increasing sophistication of the parties entering into these contracts on both sides.”

Key areas of enforcement may include banks’ compliance with the Bank Secrecy Act regarding anti-money laundering, how deposits are held and how the scheme is marketed to consumers, and credit underwriting standards, particularly for consumer loans.

“Regulators are going to spend time ensuring that the institutions that provide these types of services to third parties that interact with customers on their behalf are able to be as compliant as they would be in any other line of business,” said David Sandler, co-chief executive officer for investment banking for financial services at Piper Sandler.

“It’s going to have a profound impact on the space and the entrance to this space,” Sandler said. “It already has.”

Contractual rights to look out for

Some believe the growing regulatory environment will prompt banks to tighten contract terms for compliance practices to set expectations with fintech partners up front.

“I think the battleground is going to be in these contracts,” Chorazak said.

Banks may request additional audit rights to inspect or monitor fintech partners’ operations. Banks should protect their rights to obtain adequate information about how the fintech handles customer alerts and how it resolves disputes or collects consumer data, and they should not rely solely on what a fintech promises to disclose, but set up mechanisms for information flow as a contractually appropriate one, said Chorazak.

Banks should also consider the right to exit a partnership if the fintech is not performing, Chorazak added. While things may be going well, banks should consider whether a fintech partner demonstrates a sophisticated level of compliance expected of the bank by its own regulators, Chorazak said.

“If it’s a view that the bank isn’t aware of, or doesn’t have enough answers to provide about the nature of the fintech’s operations or activities, I think that’s a red flag for the agencies,” Chorazak said.

Banks are also using technology to automate compliance when managing their fintech partnerships, said Greg Watson, CEO of Napier, a compliance software provider that counts State Street Corp. and Credit Suisse as clients, in an interview.

“The neobanks that are coming out today are a little more sophisticated than what we’ve seen a few years ago,” Watson said.

Long-term shift on debit programs

Banks operating in a highly regulated industry are subject to regulation, not only for compliance, but also for operational reasons. For smaller banks in BaaS, there is tension between pursuing growth and enjoying the benefits of remaining below the $10 billion threshold.

Banks with less than $10 billion in assets are exempt from the Durbin amendment and are eligible to charge higher interchange fees for processing debit card payments. The rule affects the strategy of smaller banks that support fintech debit card programs, where the partners typically share the interchange revenue.

“If your focus is to keep this bank-as-a-service or other fintech partnership models, you have to weigh that against the benefits or economies of scale over $10 billion for your core lending business,” said Cliff Stanford, a partner at Alston & Bird and head of the firm’s banking regulation team.

Although many of the smaller banks in BaaS choose to manage their balance sheets to stay below the $10 billion threshold, they may choose to exceed it if they are affected by the demand for scale.

“People are realizing that business models funded entirely by exchanges are not necessarily going to be profitable,” said Jonah Crane, partner at advisory and investment firm Klaros Group. “You could see a shift away from exchange-driven business models initially, which I think will make the $10 billion threshold less important.”

Credit card partnerships that attract major banks

Larger banks also take a stake in BaaS. Larger players have the advantage of handling more complex programs on a significant scale, for example taking insurance risk in credit card issuing. Goldman Sachs, for example, is the credit card issuer for Apple Inc., while Wells Fargo & Co. issues credit cards for a rental payment program designed by Bilt Rewards, an emerging fintech company that raised $150 million in funding at a $1.5 billion valuation in October.

“It’s very difficult to compete in the credit card space. It’s kind of a game of scale, and it’s harder to differentiate yourself,” Crane said.

First National Bank of Omaha is another credit card issuer supporting fintechs through Bend by FNBO, an internal fintech venture launched in August. The platform announced its first fintech partner in November, Greenlight Financial Technology Inc., to issue credit cards aimed at parents using Greenlight’s application.

First National Bank of Omaha entered the space in part because it has had an established team specializing in issuing co-branded credit cards for traditional industries and underwriting loans, said Marc Butterfield, president of Bend by FNBO.

“Part of our mission is to disrupt the legacy business, but what I think is great is strategically, we look at it and say, ‘If we don’t do it, someone else will,'” Butterfield said.